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Early in
gold’s secular bull, contrarian investors looked to real interest rates
as one of this metal’s primary drivers. Eleven years ago when gold
still languished under $300, mainstreamers scoffed at the notion that there
would ever be sizable gold investment demand. But then, as now, negative real
rates create strong incentives for bond investors to deploy significant
fractions of their portfolios in this unique asset.

In the
financial world, the word “real” simply means after inflation. It reflects
capital’s actual purchasing power
rather than its nominal, or face, value. And ultimately purchasing power is
all that matters. Savers invest the hard-earned surplus fruits of their
labors in order to increase their future purchasing power. They forgo
consumption today in order to grow their capital’s utility to afford
higher future consumption.

So in order to
be successful, investors must earn
returns exceeding inflation. As any country’s central bank grows its
money supply, relatively more currency bids up the prices of relatively fewer
goods and services. These money-driven general price increases are called
inflation, as they result from an inflating
money supply. Inflation insidiously erodes investors’ nominal returns,
sapping their purchasing power.

For stock
investors, inflation’s persistent threat is manageable. The annual
returns earned in great stocks prudently bought when their prices were relatively
low are usually well into the double digits. So it isn’t too hard to
stay ahead of inflation in the stock markets. But for bond investors,
inflation is a terrible threat. It vies with rising
interest rates for the crown of being the single most destructive force to
growing capital.

And it’s
easy to understand why, bond yields are fixed and much lower than stock
returns. If you invest in a bond that yields 5%, but general price levels are
rising by 3% annually, the actual utility of your capital is only growing by
2% a year. Amazingly such paltry real returns are
acceptable to most bond investors. They value perceived safety more than
capital appreciation, so their expectations are low.

But sometimes
real rates are driven into negative
territory. Inflation exceeds bond yields, which means investing in bonds
actually leaves investors poorer in real terms! Negative real rates
aren’t natural, they only result from extreme central-bank meddling.
When central banks artificially manipulate interest rates, which are the
price of capital, too low, negative real rates result. They are the bane of
bond investors.

If you can
only earn 1% yields in bonds, but inflation is running 3%, your
capital’s purchasing power is shrinking
by 2% annually. Why even bother buying bonds at that point? When a supposedly
safe asset is slowly destroying your capital, it’s time for prudent
investors to move elsewhere. And that is where gold comes into play. Negative
real rates have always created some of its most bullish conditions possible.

In normal
times when bonds yield positive real returns, the primary criticism against
gold is it has no yield. Why buy gold and earn nothing when bonds earn
something? But once real rates are forced into negative territory, this
argument vanishes. Zero returns are certainly superior to negative ones. But
more importantly, the inflation associated with negative real rates ignites
gold price gains far exceeding that inflation.

Inflation and
negative real rates have always been inextricably linked. In fact, way back
in July 2001 when I wrote my original essay in this
series, I led off with a Fed
official’s quote. He wrote, “The Fed’s attempts to
stimulate the economy during the 1970s through what amounted to a policy of
extremely low real interest rates led to steadily rising inflation that was
finally checked at great cost during the 1980s.”

Talk about
deja vu! Does the Fed attempting to stimulate the economy with a policy of
extremely low real interest rates sound familiar? This exact thing has
happened in spades since 2008’s stock panic! And one key result was
very predictable, surging gold prices. When the Fed actively punishes savers
for lending their precious surplus income, a growing fraction of them wisely
flock to gold for protection.

This first
chart looks at real rates and gold over the past decade or so, during
gold’s secular bull. The black line is the baseline bond yield as
measured by 1-year US Treasury bills, the nominal return. The white line
shows the annual change in the US Consumer Price Index, the most widely
accepted inflation gauge. When inflation is subtracted from nominal yields,
the blue real-interest-rate line is the result.

This past
decade hasn’t been kind to bond investors. The Fed’s easy-money
policies forced real rates into negative territory for years at a time. It
all started in 2001, when the Fed responded to a cyclical stock bear by
slashing its benchmark interest rates. This put irresistible downward
pressure on all bond yields. Interestingly after averaging just $272 in all
of 2001, gold finally broke out above $325 in late 2002 as real rates first plunged deeply below zero.

These negative
real rates were absolutely a key driver of this secular gold bull’s
early advances. They nullified the standard gold criticism that it
doesn’t pay a yield, attracting in growing legions of weary bond
investors. As real rates remained negative into 2005, gold continued to
relentlessly rally. After directly manipulating bond yields sharply lower,
the Greenspan Fed didn’t effectively restore them until 2006.

And as you can
see above, as real rates shot positive that year gold stalled out. It
consolidated sideways for well over a year until the Fed started panicking
again about the subprime-mortgage crisis. So once again it ramped up its
printing presses and cut the key interest rates it directly controls. All
bond yields followed, and real rates started plunging again. Gold surged to
dramatic new bull highs thanks to this event.

Things had
started to stabilize in early 2008, but then that once-in-a-century stock
panic slammed into the markets with breathtaking fury. So the Fed frantically
started slashing rates again, this time forcing them near zero under Bernanke. Gold once again started rallying
rapidly and never looked back. Even when CPI inflation temporarily went
negative, bond investors remained skeptical with nominal yields so low.

Gold’s
utterly massive post-panic advance didn’t stall out itself until late
2011, when deeply negative real rates started climbing again on slackening
inflation. But as real rates remained far from positive territory, gold never
gave back much of its recent years’ big gains. With the bond markets
yielding next to nothing, gold has remained a very attractive destination for
capital. And I don’t expect this to end anytime soon.

Since real
interest rates are the difference between nominal bond yields and inflation,
let’s consider the coming years’ outlook for each in turn. It was
right after the stock panic the Bernanke Fed made the unprecedented decision
to slash its federal-funds rate to zero. This crushed the yields on bonds, as
evidenced by the black 1y-Treasury-yield line above. They have been
languishing near zero ever since.

So the only
way bond yields are going to rise back up to normal levels that don’t
penalize savers is when the Fed lifts its zero-rate siege. And it ain’t
gonna happen anytime soon, by the Fed’s own adamant declaration. The
Federal Reserve makes interest-rate decisions at its Federal Open Market
Committee meetings, which are held eight times a year. The latest happened in
late October, just a month ago.

In that recent
meeting’s statement, the Fed wrote that it “currently anticipates
that exceptionally low levels for the federal funds rate are likely to be
warranted at least through mid-2015.” Over and over again, Fed
officials have said they want to keep nominal rates at “exceptionally
low levels” until well after the US economy starts recovering. So
currently the Fed is effectively pledging zero rates for several more years!

With the
fruits of this anti-saver policy being dismally low yields, the inflation
rate is almost irrelevant. Until the Fed tightens massively and pegs its own
short-term rates back up to 2%+, a vast increase from here, negative real
rates are guaranteed. Nevertheless,
the degree of inflation experienced in the coming years will determine just
how negative real rates will be. The lower they go, the more bullish for gold.

And that
requires a look at the CPI, the definitive inflation gauge today. I only use
it in my essays because it is widely accepted by economists and traders,
although it certainly shouldn’t be. The CPI is riddled with problems,
and had a major methodology change in 2006 to minimize the impact of price
increases on the headline index. The true inflation rate is much higher than
the watered-down CPI suggests.

Remember that
inflation is a monetary phenomenon.
As the Fed creates new dollars faster than the underlying economy is growing,
relatively more chase relatively less goods and services. Inflation is the
resulting bidding up of their prices. Therefore the true inflation rate is
much closer to money-supply growth. As I discussed in depth in an essay a couple weeks
ago, this is actually running between 8% to 10% annually!

The
CPI’s 2% is wildly understated, as you can easily prove in your own
life. If you track your expenses with software like Quicken, run some reports
on what your costs of living were in 2008 compared to 2012. Nearly everything
you and your family need to survive, from food to shelter to other expenses
to insurance is seeing annual price
increases much closer to 8% than 2%. Our cost of living is rising
dramatically.

This reality
isn’t reflected in the CPI for political reasons. The politicians in
Washington employ the statisticians who compute the CPI, and they don’t
want to see higher reported inflation. Higher inflation scares Americans, who
get anxious and complain and vote out incumbents. It also hurts the financial
markets, leading to the same political outcome. Most importantly it limits
Washington’s crazy overspending.

Higher
reported inflation would lead to higher interest rates, dramatically forcing
up the ultra-low Treasury yields and hence multiplying Washington’s
gigantic interest expense. Higher inflation rates also drive up
cost-of-living adjustments on welfare programs, which further cut into the
discretionary spending available for politicians’ pet projects. Thus no
one wants to see reported CPI inflation rise significantly.

But this is a delicate balancing act. If the CPI is too drastically
underreported compared to what traders and their families are actually
experiencing, they will start to lose faith in this inflation benchmark. And
at that point, inflation expectations
will soar. The Fed fears nothing more, as Bernanke often states in his
speeches. So in order to remain credible, the CPI has to continue rising on
balance in the coming years.

Rising
inflation coupled with flat bond yields near zero means real rates are going
to continue trending deeper into negative territory. And that is fantastic
news for gold. Every additional basis point real interest rates are driven
below zero intensifies the pain for bond investors. So more and more
prudently exit the poverty machine of bonds and park some capital in gold,
which will easily outpace inflation.

This has
always been the case, as the last major episode of negative real rates
abundantly proved. Way back in May 2001 as real rates threatened to go
negative again for the first time in
decades, I formally recommended our subscribers buy physical gold coins
when gold was near $264. I’ve recommended gold continuously ever since.
And a key part of the initial reason, a huge
contrarian call, was the looming negative real rates.

This next
chart expands the time frame all the way back to 1970. In addition, the real gold price is shown
as inflated by the CPI. Before the Fed spent the 2000s mostly panicking, we
hadn’t seen an episode of continuous negative real rates since the 1970s. And gold’s
mind-boggling bull market experienced back then is rightly the stuff of
legends. Negative real rates drive gold investment demand like nothing else.

While gold is
approaching similar real levels to what it saw in the late 1970s, the
character of its advance this time around is radically milder. In its famous
parabolic blowoff between November 1979 and January 1980, gold skyrocketed
128% higher in less than 11 weeks!
It more than doubled in a matter of months as a popular speculative mania set
in and mainstream investors rushed in droves to buy into that superspike.

The latest interim high in
gold’s secular bull happened in August 2011, during the last
Congressional debt-ceiling debate that led to the current fiscal-cliff
threat. But instead of taking less than 3 months for its final 125% gain,
that run took 31 months this time
around. So despite gold’s real heights, so far it has advanced vastly
slower than it did in the terminal days of its last secular bull several
decades ago.

And
gold’s ultimate peak in this secular bull once mainstream investors
finally fall in love with this metal en masse ought to be far higher than the
last one anyway. Why? The money supply has grown far faster than the global
gold supply over the decades since. On average over the long term, mining
adds only around 1% to the global gold supply annually. This
naturally-constrained slow supply growth is why gold is history’s
ultimate form of money.

In the 32
years since gold’s last secular bull peaked, 1% growth compounded
annually yields a global gold supply just 37% larger than what was available
for purchase back then. An aggressive 2% leads to 88% growth. But meanwhile
the broad US money supply, MZM today, has ballooned from just $853b in
January 1980 to $11,270b today! This is staggering 1222% monetary growth,
which equates to a compound annual growth rate near
8.4%.

So while the
world’s above-ground gold supply spent three decades growing on the order
of 37% to 88% thanks to mining, the Fed has inflated the US dollar supply by
1222%. So the amount of dollars available to chase gold as it becomes more
popular are vast beyond imagining compared to what was available at the apex
of the last secular bull. An 8%+ annual money-supply growth rate dwarfs a
1%-to-2% gold one into inconsequentiality.

Today’s
secular gold bull is therefore destined to peak at real levels multiples higher than what we saw back
in early 1980. And just like in that last secular bull, negative real rates
will be a major driver. The longer they stay negative, the more they will
sour bond investors on getting poorer for lending their hard-earned surplus
capital. As they migrate into gold, they will continue bidding up its price,
attracting others.

And this
virtuous circle of bond flight capital migrating into gold will be massively
larger this time around, for another simple reason. Back in 1970 before real rates went negative and catapulted gold higher, nominal
yields were running around 4% at worst. Today they are less than 0.2% for a
1y Treasury! Rising interest rates are far more dangerous to bond investors
than inflation, and the risks today are staggering.

After bonds
are issued at a fixed interest rate, they trade in
the secondary markets. And supply and demand forces their yields in line with prevailing interest rates.
So if you buy a bond for $1000 yielding 3%, but market rates rise to 6%, its
market value will be cut in half. New buyers will only be willing to pay $500
for a bond yielding $30 per year, as that will bring its effective yield up
to the prevailing 6% level.

So back in the
1970s when interest rates surged from 4% to 16%, bond investors were
devastated. If they were in longer-term bonds and didn’t hold to
maturity, they could have taken losses of up
to 75% of their capital on rising rates. Meanwhile today the starting
point for yields isn’t 4%, but 0.16%. So if they merely climb back up
to 5% like they were before the stock panic, that is a 31x increase as
opposed to only 4x in the 1970s!

The price risk
on bonds today with interest rates near record lows is radically higher than
it was in the 1970s during the last negative-real-rates episode. And a variety of market and fiscal events could easily drive bond yields way higher
than 5% this time around too. So bond investors caught in a rising-rate
environment, especially if it happens rapidly, could face losses defying
belief. This makes gold far more attractive.

Not only is
the Fed guaranteeing negative real rates for years to come, but its fast
ramping of the money supply ensures even reported inflation is going to rise.
And as real rates plunge more and more negative, the principal risk faced by
bond investors with prevailing interest rates near record lows is
unprecedented. Today’s negative-real-rate environment is far more
bullish for gold than even the 1970s one proved to be.

At Zeal we are
ready. We’ve been playing the contrarian game and buying up dirt-cheap
gold and silver stocks in
recent months as they’ve been left for dead. These miners are trading near panic levels
relative to gold, as if the metal was trading at less than half its current price. This anomaly can’t and
won’t persist, and negative real rates are just one of many bullish
factors that will drive far higher gold-stock prices.

You ought to
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The bottom
line is negative real interest rates create the most bullish environment
possible for gold. They force prudent bond investors to shift capital into
gold to stay ahead of the ravages of monetary inflation. And since the Fed
has crazily forced yields to record lows, today’s bond investors face
the greatest risks for the biggest losses ever witnessed. Gold offers not
only a refuge, but fantastic appreciation potential.

And these negative
real rates are going to persist for years to come. The Fed has promised to
keep its asinine anti-saver zero-rate policy in place “at least through
mid-2015”. Meanwhile this central bank’s high monetary inflation
rate is gradually forcing the CPI higher to maintain credibility among
traders. And the longer real rates remain negative and the deeper they sink,
the more bullish it is for gold investment demand.

Adam Hamilton,
CPA

November 23,
2012

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